Free lunch cancelled as rates eat forward points

NZ-based fund managers might be eating out less often after losing the long-standing ‘free lunch’ offer for hedging global assets.

According to a BNZ research paper published this month, local fund managers may have to review hedging strategies after NZ interest rates ‘crossed’ below US rates for the first time in decades.

Typically, NZ-based investors have earned ‘forward points’ by hedging the local currency – housed in a higher interest rate environment – against the US dollar.

“To give an example, an exporter or local fund manager with offshore assets who hedged one-year forward USD exposure has been able to bank an average annual 2.6% ‘yield pick-up’ since 2000,” the BNZ paper says.

“… Exporters and local fund managers have often seen this yield pick-up as a benefit to hedging foreign exposure and this has made the decision to hedge easier.”

However, the paper, commissioned by BNZ senior markets strategist Jason Wong, says after trending down for four years NZ interest rates have now dipped below the US with further falls likely.

“Over the next twelve months or so, the current minus 0.4% yield spread could well widen to minus 1.5% or so,” the BNZ research says. “The free-lunch that exporters and local investors have enjoyed for so many years quickly morphs into a free lunch for importers.”

But in spite of the increasing cost of hedging, there were still “good reasons” for NZ fund managers exposed to offshore assets to manage currency risk, the ‘End of the free lunch’ paper says.

Nonetheless, the paper says with local interest rates expected to stay low for some time as US rates rise further the NZ dollar was unlikely to appreciate in the medium term.

“Thus, we see some merit in exporters and local fund managers strategically targeting a lower than usual hedging ratio, with the low NZ-US rate differential likely to be a key variable that holds back NZD performance over the next couple of years,” the report says.

While global fixed income assets are usually fully-hedged to the NZ dollar, offshore equities come in a variety of flavours. For example, some managers offer either hedged or un-hedged versions of the same international shares fund while others manage currency exposure within the product.

Over the 12 months to June 30, currency exerted a major influence on international share returns, according to the latest Melville Jessup Weaver quarterly investment survey. The unhedged global equity index returned 20.1 per cent and 8.4 per cent over the quarter and 12-month periods, respectively, compared to 12.1 per cent and 3.9 per cent for a fully-hedged variant.